Distinguishing between public and private REITs

We recommend that investors not be shy about asking for full disclosure of the relationship between the REIT, its advisors, and the management companies. REITs often involve conflicts of interest that aren’t clearly disclosed or pay significant above-market fees to directly or indirectly related entities or affiliates that ultimately lower the cash flow and return on investment available for distribution.

Public REITs are traded on the major stock exchanges and thus must meet strict SEC reporting requirements:

• Liquidity: Public REITs trade every business day on a stock exchange and thus offer investors the ability to buy and sell as they please. Of course, as with other similarly liquid investments (like stock in companies in a variety of industries), liquidity can have its downside. More-liquid real estate investments like REITs may inspire frequent trades caused by making emotional decisions or trying to time market movements.
• Independent board of directors: A public company must have directors, the majority of whom are independent of its management. Shareholders vote upon and elect these directors, but that is no guarantee of their competency.
• Financial reporting: Public REITs, like other public companies, must file comprehensive financial reports quarterly.

We recommend that you stay away from private REITs unless you’re a sophisticated, experienced real estate investor willing to do plenty of extra research and digging. Because they’re not publicly traded, private REITs don’t have the same disclosure requirements as public REITs. This difference means an investor in a private REIT had better carefully scrutinize the prospectus and realize that the private REIT has the ability to make changes that may not be in the investor’s best interests but that reward the private REIT sponsors or their affiliates. Ask what commission is deducted from your gross investment to arrive at your net investment. You may be surprised at the “acceptable commission rates” for private REIT investments, especially when you compare your experience with most mutual funds with very low competitive fees and no commissions with no-load funds.

Taking a look at performance

So what about performance? Over the long term, REITs have produced total returns comparable to stocks in general. In fact, REIT returns historically have been as good as or better than stock returns, whereas REITs have also generally been less volatile than stocks. In the context of an overall investment portfolio, REITs add diversification because their values don’t always move in tandem with other investments.

One final attribute of REITs we want to highlight is the fairly substantial dividends that REITs usually pay. Because these dividends are generally fully taxable (and thus not subject to the lower stock dividend tax rate), you should generally avoid holding REITs outside of retirement accounts if you’re in a high tax bracket (for instance, during your working years).

Investing in REIT funds

You can research and purchase shares in individual REITs, which trade as securities on the major stock exchanges. An even better approach is to buy a mutual fund or exchange-traded fund that invests in a diversified mixture of REITs. Some of the best REIT mutual funds charge 1 percent per year or less in management fees, have long-term track records of success while taking modest risks. Vanguard’s Real Estate Index Fund charges just 0.12 percent per year in fees and has produced average annual returns of about 10.2 percent since its inception in 1996.

Vanguard also offers an REIT ETF (exchange-traded fund) through most discount brokers and boasts a low management fee of 0.12 percent. (You can buy it without any brokerage fees through Vanguard.)

In addition to providing you with a diversified, low-hassle real estate investment, REITs offer an additional advantage that traditional rental real estate doesn’t. You can easily invest in REITs through a retirement account such as an IRA or Keogh. As with traditional real estate investments, you can even buy REITs and mutual fund REITs with borrowed money (in nonretirement accounts). Although risky, you can buy with 50 percent down, known as buying on margin, when you purchase such investments through a brokerage account.

Table 4-1 contains a short list of the best REIT mutual funds and ETFs currently available.

If you really have your heart set on becoming the next Warren Buffett and you enjoy the challenge of selecting your own stocks, you can research and choose your own REITs to invest in. Both of the investment research publications Morningstar and Value Line, which can be found at many local libraries as well as online (www.morningstar.com and www.valueline.com ), produce individual stock page summaries on various REITs. In addition to having a professional manager deciding what REITs to buy and when, the mutual fund REITs listed in Table 4-1 also provide consolidated financial reporting. If you purchase individual REITs, you have to deal with tax statements for each and every REIT you’re invested in.

Paying for 1031 availability and “hassle free” management

Although we prefer REITs, tenants in common (TIC) can be right for certain investors with significant net worth and no desire to directly own real estate — as long as they fully understand the benefits and drawbacks. The minimum investment for most TICs is measured in the hundreds of thousands of dollars, although some TIC sponsors offer fractionalized ownership for as little as $50,000.

Traditionally, owners with significant equity can use a tax-deferred exchange (also known as a 1031 exchange) to either sell or exchange into a larger property, or simply continue to hold and refinance the highly appreciated property to generate cash for additional real estate investments, which also offer additional tax benefits. But TIC candidates are usually real estate owners currently in or contemplating a tax-deferred exchange and are facing the strict time limits and haven’t been able to find a suitable property on their own. (See Chapter 18 for a discussion of the tax-deferred exchange.)

If you’re considering a TIC as an alternative for your tax-deferred exchange, verify in advance with your tax advisor that your transaction qualifies. Doing so is critical. Don’t overlook this important step. A tax-deferred exchange is limited to like-kind property with specific rules about how you hold title of both the relinquished and replacement properties. If the property being sold is directly owned, the transaction most likely meets the requirements and isn’t taxable at the time of sale as long as the TIC property is a direct ownership of real estate and not a security. But many investors may find that the property they’re selling is a partnership interest in real estate and doesn’t qualify for the tax-deferred treatment because the two investments aren’t like-kind. It’s also true if the IRS deems the replacement property ownership interest to be a security or anything other than direct ownership of real estate. Obtaining competent legal and tax advice in advance is essential, or you may have a very unpleasant surprise when the IRS declares that your transaction is fully taxable.

However, the TIC sponsors know that their product can be a tough sell, so they target owners of highly appreciated properties who are considering a tax-deferred exchange but are at a stage in their lives in which they’re not interested in expanding their real estate empire. Or they may have used all of the tax benefits of depreciation (see Chapter 18) and really should sell their property and simply pay the capital gains but are just simply unable to stomach the thought of paying the taxes even if it is not their best investment decision.

A downside of these TIC investments is that they’re often extremely expensive. Because the majority of the potential purchasers for these real estate investments are coming out of a tax-deferred exchange, they’re subject to tight time limits. The IRS requires 1031 exchanges to identify the replacement property within 45 days of the close of escrow of the property being sold. And the replacement property transaction must be completed within 180 days. Please see Chapter 18 for more details.

Thus, the syndicators of the tenants in common product are always standing by with a pending real estate acquisition for those buyers whose time limits are running short and who need to identify and close on a property within the time limits imposed by the IRS. If the owner is unable to meet the deadlines, they lose all of the tax deferral benefits, so they’re often willing to overpay. The TIC sponsors know that many real estate investors panic and commit to real estate investments that aren’t prudent or suited to them just to avoid paying the capital gains tax.

In exchange for this flexibility and readily available product, the syndicators have prepurchased these properties and rolled them over to the tenants in common investors at full market value, which is a higher price than the properties would sell in an arm’s-length transaction in a competitive free market. (An arm’s-length transaction simply means between an independent buyer and seller — for example, not related parties like relatives.) Further, the syndicators usually associate with financial advisors who receive hefty sales commissions of 5 to 7 percent and even as high as 10 percent of the investors’ initial investment, plus a spread to the TIC sponsor to cover its internal marketing and administration costs. Then many TIC sponsors have separate advisory firms that are closely held by the principals of the sponsor, and they commonly charge upfront, plus ongoing, consulting fees. Thus, the purchaser of a tenants in common real estate investment is paying top dollar for the property and is only receiving the benefit of as little as 90 percent of her gross investment because of commissions and fees paid upfront.

The TIC sales pitch also places a heavy emphasis on the desirability of eliminating the trials and tribulations often associated with an owner trying to manage his own property. TIC sponsored properties are professionally managed by the sponsor or a property manager of their choice, and not at the most competitive fees.

Asking whether TICs are right for you

Be aware that TIC sponsors often provide attractive teaser rates of return that are guaranteed only for the first couple of years. For example, a review of the private placement offering may indicate that investors will receive a 7 percent cash distribution per year for the first two years only. This rate may potentially entice investors who have built up significant equity in their real estate holdings but haven’t seen their cash flow increase as fast.

Also, like many other financial products, a lot of effort goes into the promotion and sales of TICs, often through independent investment advisors, which translates to a lot of overhead to cover. You typically get slick marketing materials and are referred to fancy websites or supposedly free seminars reminiscent of the late-night infomercial gurus. These promotional efforts are high on fluff and scarce on details.

You need to determine whether TICs are right for you by asking your investment advisor and the TIC sponsor for written answers to some basic questions before sending them your money:

• Who’s receiving commissions and how much? The TIC sponsor receives a commission or spread right off the top, plus the investment advisors (broker) who refer their clients get a piece of the action, too.
• Was the offered property recently acquired and at what price? Many TIC investors purchase the properties and then resell them within days or months at full retail or top of the market pricing, so it may be informative to know how much the TIC sponsor has made on the investment in addition to the commissions.
• How much of my net investment is actually invested in the property? At the end of the day, after everyone has been paid, how much of my investment actually is invested into the property?
• How solid is the tenant(s) occupying the property and what are the terms and length of their lease? The property may be a Class “A” building with a Fortune 500 tenant today, but how long is the tenant committed to the space? Are there out clauses in case of a merger or the tenant relocates? (Out clauses are any language in the lease that would allow the tenant to legally and unilaterally break the lease with only limited or no further financial obligation.) What is the likely demand for this property should the unexpected happen and the Class “A” anchor tenant leaves? What are the rent increases, and do they keep up with expected inflation?
• What’s the amount and timing of the cash distributions? If based on a certain percentage rather than actual operating results, are the distributions guaranteed, and if so, for how long and by whom? Many TIC sponsors use an above-average cash distribution as a hook to entice new investors, but property performance may not generate enough cash to cover the distributions, and investors may actually be required to cover operating losses. Where’s that fact in the fancy slick-paper full-color brochure?
• What are the charges for property and asset management? Most TIC sponsors have affiliated property management firms that handle the day-to-day management — but at fees always toward the high end of reasonable. Also, there may be another layer for an asset manager or advisory firm that supervises the property management company, and they’re also often controlled by or associated with the TIC sponsor. You have no guarantee that the asset or property management is qualified or competent, so be sure to ask questions about their experience and credentials; excellent management is extremely important. Remember that this is a passive investment, so you have little say in making any changes if they don’t meet your expectations.
• How liquid is my investment, and does the sponsor offer a buyback or loan program? Currently, there’s no viable secondary market for TIC investments, so you’re at the mercy of the TIC sponsor or possibly another investor who’d be willing to buy you out. Anyone buying a fractional ownership is going to expect and receive a significant discount from the actual asset value. Have you ever tried to sell a timeshare interest at the price you paid originally from the developer?

Of course, many investors are attracted to the fact that someone else (all TIC sponsors claim to be experts) is tracking down the properties and doing all of the due diligence, and you definitely pay a price for these benefits. So follow the money and make sure you’re comfortable with this investment, because it isn’t easy to sell should your needs change.

Our advice for investors considering TIC: Buyer beware. Do your due diligence and speak to your independent real estate, legal, and tax advisors before making any investment. Also, explore the alternatives of other forms of real estate investments or simply sell the real estate and pay your capital gains taxes and taxes on any recapture of depreciation.

Thinking ahead about landlord/tenant division of duties

There are several different types of net properties. However, many are erroneously called triple net leases when they are not. So you need to be careful and review the actual lease document to determine the true net aspects, as not all leases are the same.

The one common denominator is that all net leases have some aspect of the tenant paying for a portion or all of the operating expenses, taxes, insurance, maintenance, repairs, and even capital improvements. But, there are absolute triple net leases (sometimes referred to as bond leases) where the total responsibility rests with the tenant. In a bond lease, the tenant is fully responsible for the repairs, maintenance, and operating expenses (including taxes and insurance) of the entire property without any limitations.

The net net net leases (or NNN leases or triple net leases) are similar to the bond lease, with the tenant being responsible for all operating and fixed costs of the property, while the owner is still responsible for the maintenance and repair of the building envelope (roof, foundation, structural bearing walls), plus there are limitations on capital improvements or upgrades that the landlord can pass on to the tenant.

Another type of net lease is the net net lease (or NN lease or double net lease), which is an investment where the tenant pays most operating expenses. As in the net net net lease, the landlord retains responsibility for the structural components such as the foundation, bearing walls, and roof, but is also responsible for major building systems such as HVAC equipment, electrical, plumbing, and driveways and parking areas.

If you’re considering an investment in any type of net lease, you must carefully review the lease to determine exactly who is responsible for each of the components of the building. You should also be very specific on your requirements or expectations about the quality of the maintenance of the property as well as the details of the insurance coverage, including making sure you’re named on all polices as an additional insured. If you’re a novice, be sure to use the services of a real estate attorney or lease expert to prepare a lease abstract, which is a summary of the pertinent information from the lease. Robert is often retained as an expert in lease interpretation where expensive litigation is driven by even experts who can’t agree on the exact nature of who is responsible for what aspect of the building maintenance and repairs and certain other expenses.

The type of triple net lease that is most often available to investors typically involves a fast-food franchise, restaurant chain, local chain drugstore, or similar retail outlet. The owner buys the building, which is built precisely to the tenant’s specifications, and the tenant then enters a long-term, fixed-rent lease in which she pays for almost everything, including the property taxes, insurance, utilities, and most of the maintenance. Many companies rely heavily on the sale/leaseback of their newly built locations. The advantage to the tenants is that they free up capital to expand and grow their primary business, which isn’t real estate.

Originally, these investments were offered by developers who worked exclusively with such companies, but now many brokers and real estate firms specialize in the marketing and sale of triple net properties.

The owner should regularly inspect the property under any type of net lease that isn’t a bond lease because she retains ultimate control — and thus the liability — if the tenant fails to properly maintain the building. Also, many triple net lease tenants will perform only cosmetic repairs, especially as they approach the end of their lease commitment. For example, under their net lease they may be required to replace very expensive roof-mounted HVAC units, but if fewer than five years remain, they will make Band-Aid repairs or even just live without the HVAC and let the landlord regain possession of a severely depleted building with excessive wear and tear. Then, the owner has the difficult challenge of attempting to recoup her costs to bring the building back to a marketable condition to lease to a new tenant. Owners of any type of building with a net lease would be wise to hire a competent property manager who specializes in that property type and pay them the reasonable management fee that they charge to manage the property, including property inspections and demand letters to tenants requiring them to address deferred maintenance. If you do this throughout the net lease, you avoid the almost impossible task of determining why the property is in poor condition at the end of the lease period.

Robert has seen a litany of litigation between the owner and tenant over issues of exactly what type of net lease exists, with the key dispute being an interpretation of who is responsible for the repair and maintenance of building components. These lawsuits often result from third-party injuries, with the landlord and the tenant each accusing the other of failing to properly inspect, maintain, and/or repair the property.

Minimizing the risks of triple net investments

Lately, the returns available on these triple net properties have been low due to the perception that they’re essentially a risk-free investment. However, should the tenant find that the location isn’t profitable, you may find yourself owning a customized taco stand that requires a lot of modifications to be a viable location for another business.

Triple net real estate investments are suitable for some, but stay away from them unless you’re really comfortable with the tenant and the location and are willing to accept relatively low rates of return. Also, look closely at the rent structure because most leases have many years of flat, fixed rental income with an occasional upward adjustment that’s likely to be lower than the future market rent. Triple nets may make some sense if you can consistently earn a return that’s higher than a comparable bond investment. But you always run a risk with any single-tenant investment property, and major national-brand fast-food and drugstore chains can (and do) go out of business. We advise investors interested in this type of investment to consider the diversification and lower risk associated with purchasing REITs (discussed earlier in this chapter) that hold triple net properties (among others) rather than a direct purchase of a triple net property.

Robert is aware of many triple net properties that probably seemed like great deals at the time buyers purchased them with a national credit tenant (an expanding company that has a very solid financial balance sheet) on a long-term lease. What could go wrong? A lot. With leases as long as 50 years and set rents that are modestly adjusted over time, you run a serious inflation risk unless the rents can adjust to fair market rent at least every 5 to 10 years. The more specialized the use of the building by the tenant, the more challenging your life can be if the tenant vacates, so consider whether the tenant improvements are suitable or can be modified at a reasonable cost to suit the needs of a replacement tenant.